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Netflix Insiders Take the Money and Run

As Netflix (NASDAQ: NFLX) stock has soared in 2013, company insiders have been cashing in on their stock options and heading for the exits at an alarming rate. There are many reasons that a public company's officers and directors might sell immediately after exercising stock options: They could be looking to supplement their cash earnings. They might need the money to offset tax liabilities. Or they may want to diversify their risks.

However, this behavior could also be a sign that insiders think their company's stock has become overvalued. This year's flood of insider selling at Netflix has been extreme enough that it is hard to attribute everything to "benign" motives. A more plausible explanation is that Netflix insiders haven't bought in to the enthusiasm that has caused the stock to triple this year.

If Netflix insiders are skeptical of the stock's recent run, other investors could run into trouble soon. If the company's future growth falls short of Mr. Market's expectations, the stock could easily drop by 50% or more as it did in 2011.

Steady sellingNetflix insiders have been exercising their stock options to cash in on Netflix's rapid rise since early this year. For Q1, Netflix insiders exercised options for 556,819 shares of stock at a weighted-average price of $70.30 . By contrast, fewer than 200,000 options were exercised in all of 2012 due to the stock's massive drop from its 2011 peak to the 2012 trough. Option exercises continued at a rapid pace last quarter, bringing the total for 2013 to just more than 1 million options exercised at an average price of $67.70.

Bailing out has been an equal-opportunity sport for Netflix insiders. Netflix CEO Reed Hastings stated early this year that he had options expiring every month beginning this summer, and that he planned to sell as the options hit their expiration dates . Sure enough, beginning in late June, Hastings has exercised options to buy 15,238 shares each month and immediately sold the stock, booking millions of dollars in capital gains each time.

Despite this selling, Hastings remains a major shareholder in Netflix, with more than 1 million shares held in trust. Thus, Hastings' actions do not suggest that he expects Netflix to crash anytime soon. (That said, Hastings pointedly declined to comment about whether he was "comfortable" with the valuation of Netflix stock during the company's Q2 earnings interview.)

Other company insiders have shown less faith in Netflix's potential. Just in the past two months, two of the six independent directors on Netflix's board have made major sales. In July, George Battle sold more than 23,000 shares of Netflix stock, while Timothy Haley sold nearly 20,000 shares in August. Director Leslie Kilgore (who was Netflix's chief marketing officer until early 2012 ) has been selling at a steadier pace over the course of the year, dumping nearly 40,000 shares in total.

Among prominent Netflix executives, Chief Content Officer Ted Sarandos sold more than 83,000 shares shortly after Netflix popped above $200 in May. General Counsel David Hyman began selling around the same time, and has unloaded more than 26,000 shares since May. CFO David Wells also joined the party in May, and has sold more than 30,000 shares since then.

Foolish bottom lineNetflix executives may seem confident in the company's future when they appear on conference calls or talk to the media. However, a look at what they are doing casts doubt on this facade. Numerous Netflix officers and directors are selling millions of dollars worth of stock acquired through options. Aside from Reed Hastings, most of these insiders do not have significant long-term holdings of Netflix stock.

Of course, insider selling does not guarantee that a stock is going to fall. However, the behavior of many Netflix insiders suggests that their incentives may not be fully aligned with those of long-term shareholders. By exercising stock options and selling immediately, these officers and directors are banking millions of dollars of profits based on Netflix's current stock price. If this year's Netflix stock rally turns out to be yet another bubble, these insiders will not suffer nearly as much as shareholders who are still holding their positions.

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Comments from our Foolish Readers

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When I stock goes up in value as much as Netflix has, it is not unusual for CEOs or directors to sell some of their shares to readjust their portfolio holdings to become more balanced. The CEO still owns over one million shares! His selling around 45,000 shares from exercised options is therefore, IMHO, pretty meaningless. How many shares of NFLX do the directors mentioned in your article continue to own, Adam? Could they just have been adjusting their NFLX ownership to a more reasonable level in light of its price rise and, therefore, it becoming a disproportionately large holding in their otherwise balanced portfolio?

Insiders in any companies sell their stocks from time to time. This is called financial management. Hastings still has large portion of his personal wealth tied to his NFLX stock ownership. It's not like him or any other insiders are bailing out.

Why do these people always make negative remarks about Netflix? I swear the cable companies are paying for this garbage. Also on a side not I used to be able to sign in with my normal screen name and they blocked me. I think these people are very shady and whoever reads this Do Not Get Caught Up With What They Are Trying To Say About Netflix! It's a great service and these people are just downright evil.

Dear garetjaxx11, this is a stock discussion that has nothing to do with the service the company provides. I believe that Netflix is grossly overvalued and has limited growth potential. I would never invest my money in it.

At the same time I am subscriber and like their service a lot. I would not expect the service will have to change just because the stock price goes down e.g. to 70 $.

To answer some questions that have cropped up: I deliberately mentioned that Hastings still owns around 1 million shares. I don't see any real red flags in the fact that he's selling immediately after exercising the options.

By contrast, for all of the other people mentioned, the amount of stock they sold was far more than the amount that they kept. Some high level executives (including the CFO and the Chief Content Officer) appear to have NO long-term holdings of Netflix stock. Every time that they exercise options, they cash out immediately.

To all you Netflix fans out there - nobody disputes that Netflix offers a great service. The question is whether it is worth a price of 356x earnings, especially when you look at all the potential competitors out there with boatloads of cash that they could use to buy content or even duplicate what Netflix is doing (Google and Apple come to mind). If the CFO of a company 'rebalances' his portfolio by dumping 90% of his stock that ought to give you a clue of what's to come. But hey, why should I spend my time educating you - without ample supplies of idiots like you in the world there would be nobody to take the other side of my money making trades, in this case PUT options on Netflix. I suppose it's possible that Microsoft, Apple or Google could take over Netflix - but at these prices why would they? Better just bto take them out of the equation altogether. The only real value in Netflix is its name recognition, but not worth 356x earnings. If I were Apple I would come out with a flat screen smart TV that has a Netflix-like service integrated just as Windows was integrated into hardware by manufacturers. First they use their cash to buy a much content as they can. This will take Netflix shares down to about $40. Then they can negotiate with 'overrated Reed' to buy the Netflix name on the cheap from the scrap pile.

Well, IF a large drop in price happens for NFLX, I might consider initiating a long position then when the stock price is more in line with NFLX's true valuation. I believe NFLX has got some good growth ahead for it, and if it drops investors should look at that as a BUY opportunity. I won't consider investing if the drop is justified because of kinks in NFLX's armor (underlying problems that I foresee will continue to eat away at NFLX's profit margins).

There are wifi based services for phone and tv that fist about $25 per month, in Chinese. See ITalk BB. There is no reason beyond artificial protectionist laws preventing thus type of service from going mainstream. When it does Comcast is toast. So are long distance carriers. The Netflix niche is too susceptible to competition. It's vastly over valued and the company insiders seem to know this.

You're calling out the fact that Hastings has to sell before they expire as part of your thesis? What is he supposed to do, lose out on that money? Points like that make it seem as if you're more interested in doing a hatchet job than making a reasonable case.

And I don't care who you are, when your wealth is tied to a single company in the form of stock option and your employment is tied to that same company, diversification is the only rational response. Let me tell you a little story about what happened to the people who worked at Enron...(with the caveat that I don't think Netflix is Enron 2013).

Let's see I bought my first 100 shares in '07 @$16.11. I'm told that's a return of 1,662.38% over about 5 years. Every other buy I made over the 5 year period (maybe 30 separate transactions)has made from 109% to 453%, including sales). You nay-sayers may be right, but that's the risk I accept for the way superior returns I expect to earn. I reserve the right to change my mind and sell anytime I believe it's warranted. I'm sorry for all those short sellers who have given up their ownership right. But good luck to all of you.

Those are very good points but they don't change the fact that the CFO and the CCO both own zero stock in the company they manage, it also ignores competitive threats and it ignores a PE ratio of 356x earnings. I made money on the way up too. But now is the time to dump it.

I understand your ENRON example, but cashing out $6M and leaving nothing in the company whatsoever is extreme - most people try to maximimze their overall return and the fact that they left nothing in the company at best suggests that they don't expect their NFLX return to be better than the market average. What return do they expect from NFLX? Well, they had to exercise their options, that's true, but they didn't have to turn around and sell their shares for $200. Asa I read thr article, they sold ALL their shares for about $200- the stock is now trading at more than $280 -

I just despise stock options. Not only does it make cash flow look better, but you get diluted at the same time. then you have all these employees getting ownership for no money outlay. I'd much rather see ESPP programs implemented, but pay employees more with actual payroll.

With respect to your concerns regarding the exercise and immediate sale of executive options: the number of shares involved and their exercise price indicate that these must be non-qualified options. And therefore are subject to ordinary income (not capital gains) immediately upon exercise. This certainly would be one additional reason for their immediate sale (I.e. to cover the taxes involved). Since the tax rates (federal and state)would most likely approach 40pct.

On what stone tablets is it written that officers MUST always own company stock? Sure, it might indicate to other investors that they have faith in their company but tell that to the outside investors in WorldCom, Enron, Tyco. Other than for determination of personal Worth, stock options are worthless and useless. You can't buy a pack of cigarettes or a bottle of milk with a stock option. Were I a company officer, I would rather have cold, hard cash in my hands than some promissory notes.

@FormerNetflixer: Thanks for your insight. It's pretty standard for there to be strict trading rules because of all the non-public information insiders can be privy to. And I agree that Hastings' stock sales are a little less worrisome since they were announced several months in advance and occur on a set trading plan.

However, I don't agree that dumping stock once a quarter differs from dumping stock on any other schedule. At the end of the day, a bunch of insiders have sold a large portion of their financial interests in Netflix (stock, stock options, etc.) since the beginning of the year. Ted Sarandos has sold around 127,000 shares this year at an average price near $190 (about 33% below the current market price). In other words, he didn't feel confident that Netflix was undervalued at those prices.

If that doesn't give you pause, then feel free to ignore the article. I think it's relevant for anybody who's thinking about investing in Netflix.

@nyc314: I deliberately said that I do not find Reed Hastings' actions suspicious. Of course I don't expect him to "lose out" on any money. But just because he exercised the options doesn't mean he needed to sell the stock right away. However, I think that since he already has about 1 million shares owned in trust that it's pretty understandable for him to pocket some cash. What is more troubling is the other insiders who have little or no long-term holdings of Netflix stock and are selling options right and left.

<<Ted Sarandos has sold around 127,000 shares this year at an average price near $190 (about 33% below the current market price). In other words, he didn't feel confident that Netflix was undervalued at those prices.>>

People sell stocks for all kinds of reasons unrelated to value: To pay tax bills, send their kids to school, but a new boat, fix their roof, etc. For someone rich like a Netflix executive, the reason is likely a diversification of assets without much thought to where shares might trade a few months in the future.

In my opinion, people, in general -not just officers- work in a company for their salary. They do not look upon it as investors. This is not to say they don't expect to enjoy their job, no. But they certainly would not enjoy it if not content with their compensation. And, for some strange reason, that does not quite escape me and for which there are exceptions -related to being employees- they tend not to fall in love with their employer. So, if they are not founders of the company I do not tend to expect them to invest in it. It is even dangerous for them since they could be charged with trading with insider information. Just another angle to look upon from a probably naive guy.

After running 20+ years of data through analyses, the primary conclusion is that the real signals only come when an insider buys AFTER the stock has risen 20%+ over the last six months or an insider sells AFTER the stock has fallen 20%+ over the last six months.

This would, therefore, not be considered material by the data. Which doesn't mean that Netflix stock is bound for higher prices. It just means that these trades -- in the context of tens of thousands of trades like these across the public markets spanning decades -- are not statistically telling.

Thanks for your insight, Tom. I wasn't familiar with that book but I will check it out.

Morgan: Your point is definitely valid; there's no way to know for sure what's going through a Netflix exec's head when he/she sells a bunch of shares. What I find disturbing is 1) two of the top 3 execs on the totem pole own no shares of Netflix stock, and 2) they are exercising/selling options in large quantities well before they mature. Plus, they do not have to wait to exercise their options: they vest immediately.

As a result, these execs (and this excludes Reed Hastings) have no real financial incentive to build the company's long-term value. In fact, they maximize their profit when the stock is extremely volatile as it has been for the past 2 years. That's not to say that they're not doing their best, but in my opinion there's a significant "principal-agent" problem here.

diversification is the key...you must have a few risky one to balance out the safe ones...But "most" stocks are expensive in term of $.nowadays.and I don't have the money to buy 100 shares (PCLN, GOOG) unless you bought long time ago...Money manager can sell option calls to balance out the risk...

Sending report...

Adam Levine-Weinberg is a senior Industrials/Consumer Goods specialist with The Motley Fool. He is an avid stock-market watcher and a value investor at heart. He primarily covers airline, auto, retail, and tech stocks. Follow him on Twitter for the latest news and commentary on the airline industry! Follow @AdamLLW